Stronger Euro Could Hurt Rebalancing Process

Global | Country Risk | Mon Feb 11, 2013

The appreciation of the eurohas beensizeableenough to create concerns about the already-fragile growth outlook forthe eurozone in2013 and 2014. Last week we raised our 2013 average US$/EUR forecast to US$1.34/EUR from US$1.25/EUR previously, and our 2014 projection to US$1.27/EUR from US$1.20/EUR previously. The consistently weakening Japanese yen will also be taking its toll on the international competitiveness of the eurozone, and particularly on Germany, having depreciated against the euro by nearly one-third since the middle of 2012. There are several factors behind these currency movements, but the Japanese government and central bank's concerted efforts to weaken the yen, the Fed's ramping up of asset purchases as of a couple of months ago, and the slowly shrinking ECB balance sheet amid improving sentiment, have all played a part. We have previously highlighted the actions (or lack thereof) of the ECB in supporting a stronger euro ( see our online service, February 6, 'ECB Inadvertently Propagating US$/EUR Rally'), but with ECB President Mario Draghi saying last week that the euro move was being monitored, we thought it was worth a look at the potential effects of currency appreciation.

There are several 'rules of thumb' when it comes to the effect of sustained currency appreciation on output. For the eurozone, the general consensus is that for a sustained 10% appreciation in the trade-weighted euro, output falls by around 0.5pp in the first year. The output of our in-house macro model is generally in line with this observation. Obviously this is inexact, not least because it doesn't take into account why the euro is strengthening (it could strengthen under better economic growth in the eurozone, for example). But holding all else constant, the output of the model is fairly consistent with what one would expect: weaker growth, higher imports and weaker exports dragging on the current account balance, and lower inflation. The first chart is of our previous US$/EUR forecasts, and the new ones, with average forecasts straight-lined through each quarter of 2013 and 2014 (rather than using year-end figures). The overall difference is about 7% in 2013 and 5.8% in 2014.

The estimated difference in year-on-year real GDP growth by end-2013 is -0.4pp-and with the euro bloc as a whole flatlining (our 2013 growth forecast is 0.1%),that difference could be significant.The rebound in 2014 mainly reflects the base effects of a very weak 2013; the overall level ofreal output is around 0.3-0.4pp lower by the end of 2013 and a bit less than that by the end of 2014, which is around what the 'rule of thumb' of FX appreciation would posit.In this context, our 0.1% real GDP growth forecast for 2013 for the eurozone as a whole may be in line for a slight downgrade. This would particularly be the case if the euro strengthens to US$1.40-1.45/EUR for a sustained period (though we believe at this stage that such appreciation would be only fleeting).

Stronger Euro Could Hurt Rebalancing Process

Global | Country Risk | Mon Feb 11, 2013

The appreciation of the eurohas beensizeableenough to create concerns about the already-fragile growth outlook forthe eurozone in2013 and 2014. Last week we raised our 2013 average US$/EUR forecast to US$1.34/EUR from US$1.25/EUR previously, and our 2014 projection to US$1.27/EUR from US$1.20/EUR previously. The consistently weakening Japanese yen will also be taking its toll on the international competitiveness of the eurozone, and particularly on Germany, having depreciated against the euro by nearly one-third since the middle of 2012. There are several factors behind these currency movements, but the Japanese government and central bank's concerted efforts to weaken the yen, the Fed's ramping up of asset purchases as of a couple of months ago, and the slowly shrinking ECB balance sheet amid improving sentiment, have all played a part. We have previously highlighted the actions (or lack thereof) of the ECB in supporting a stronger euro ( see our online service, February 6, 'ECB Inadvertently Propagating US$/EUR Rally'), but with ECB President Mario Draghi saying last week that the euro move was being monitored, we thought it was worth a look at the potential effects of currency appreciation.

There are several 'rules of thumb' when it comes to the effect of sustained currency appreciation on output. For the eurozone, the general consensus is that for a sustained 10% appreciation in the trade-weighted euro, output falls by around 0.5pp in the first year. The output of our in-house macro model is generally in line with this observation. Obviously this is inexact, not least because it doesn't take into account why the euro is strengthening (it could strengthen under better economic growth in the eurozone, for example). But holding all else constant, the output of the model is fairly consistent with what one would expect: weaker growth, higher imports and weaker exports dragging on the current account balance, and lower inflation. The first chart is of our previous US$/EUR forecasts, and the new ones, with average forecasts straight-lined through each quarter of 2013 and 2014 (rather than using year-end figures). The overall difference is about 7% in 2013 and 5.8% in 2014.

Euro Rising

US$/EUR Exchange Rate Forecasts, Average

The estimated difference in year-on-year real GDP growth by end-2013 is -0.4pp-and with the euro bloc as a whole flatlining (our 2013 growth forecast is 0.1%),that difference could be significant.The rebound in 2014 mainly reflects the base effects of a very weak 2013; the overall level ofreal output is around 0.3-0.4pp lower by the end of 2013 and a bit less than that by the end of 2014, which is around what the 'rule of thumb' of FX appreciation would posit.In this context, our 0.1% real GDP growth forecast for 2013 for the eurozone as a whole may be in line for a slight downgrade. This would particularly be the case if the euro strengthens to US$1.40-1.45/EUR for a sustained period (though we believe at this stage that such appreciation would be only fleeting).

Strong Euro Is A Drag On Growth

Effect of Stronger Euro on Eurozone Real GDP Growth (% chg y-o-y)

A stronger currency would also help dampen inflation, perhaps by as much as 0.5-0.8pp by the end of 2013 (reflecting both the moderation in import prices as well as the hit to economic activity).

Disinflationary

Effect of Stronger Euro on Eurozone Consumer Prices, % chg y-o-y

Perhaps most worryingfor regional policymakers, a stronger euro would hurt an already messy rebalancing process, which we have gone into great detail many times before. The eurozone has begun to run record current account surpluses on the back of a demand collapse in the periphery, combined with strong German exports to the rest of the world. A weak euro has helped the German export machine as it has allowed for exports outside the eurozone to replace those to the periphery, in large part. Taking into account that German exporters will face increasing competition from their Japanese-based counterparts benefiting from a weak yen, and the euro's strength is increasingly of concern. The euro area's current account balance as a percentage of GDP could take a hit of about 0.5% from the strengthening euro, with the Germans suffering disproportionately (their surplus shrinks by 0.6%).

Rebalancing Under Pressure

Effect of Stronger Euro on Eurozone Current Account Balance (% of GDP)

Of course, all of these calculations are ceteris paribus and do not take into account potential responses by the ECB, or the possibility that the euro's recent strength is a reflection that sentiment toward the eurozone is improving and/or the periphery is in better shape than it was a year ago. However, given that it comes against the backdrop of a major yen depreciation, the euro is at the epicentre of a global competitive currency devaluation, with the ECB's narrow mandate rendering it fairly powerless against further rounds of asset purchases by the US Fed, Bank of England and Bank of Japan. Over the medium to long term we are still relatively bearish the euro, given the likelihood of an eventual return to monetary expansion and a further flare up in the eurozone crisis. However, in the coming quarters, a stronger euro now looks more likely, which will have a negative impact on the eurozone's already weak recovery. This in turn keeps us on the bearish side of peripheral debt, which is weakening amid political concerns in Spain and Italy. And in turn, that could force the ECB to intervene, relieving upside pressure on the euro.